Wednesday, September 16, 2015

Have Central Banks Created a Crisis That They Can't Fix?

With all of the handwringing over the Federal Reserve's liftoff, there is one factor that will have a significant impact on the economy of the future, a factor that the world's central banks have been responsible for creating and yet, there is little or nothing that they will be able to do to fix it.

A report by McKinsey Global Institute, "Debt and (not much) Deleveraging" looks at what has happened to global debt since the Great Recession.  Given that a great deal of the problem that created the Great Recession was debt-related, one would hope that the world, including individuals, corporations and all levels of government, had learned a lesson from living beyond their respective means.  Unfortunately, McKinsey shows that this is clearly not the case.  Global debt levels across 47 nations (22 advanced and 25 developing economies) including household, corporate, government and the financial sector, has increased from $142 trillion in Q4 2007 or 269 percent of global GDP to $199 trillion or 286 percent of global GDP in Q2 2014.  This is an increase of $57 trillion or 40.1 percent in less than seven years.  Here is a graphic that summarizes the debt growth by sector:

Here is a graphic showing what the change in debt-to-GDP ratio looks like for each nation between 2007 and 2014:

As you can see, only five nations, Argentina, Saudi Arabia, Romania, Egypt and Israel deleveraged as a percentage of GDP over the seven year period, noting that all of these nations are considered to be developing economies.  In contrast,  the ratio of debt-to-GDP has increased by between eight and 170 percentage points for the world's advanced economies.

Let's start by looking at household debt and follow with a look at what has happened to government debt since 2007.

Household Debt:

Here are a few key facts:

1.) Only in the core crisis nations; Ireland, Spain, the United Kingdom and the United States have households deleveraged.  In the United States, household debt as a percentage of income has declined by 36 percentage points after rising to a high of 125 percent prior to the Great Recession.

2.) Advanced economies including Canada, Australia, Denmark, Sweden, the Netherlands, Malaysia, South Korea and Thailand have seen their household debt-to-income levels rise above pre-Great Recession levels.  The authors of the study believe that it is likely that these seven nations have household debt levels that are unsustainable.

3.) Eighty percent of countries in the study had higher household debt levels in Q2 2014 when compared to Q4 2007 with 74 percent of household debt being mortgages in advanced economies and 43 percent of household debt in developing economies.

Here is a graph that shows how household debt-to-income ratios for several nations have changed over the period from 2000 onward along with the change in debt-to-income level between 2007 and 2014:

Canada is one of the worst offenders with household debt-to-income rising by 22 percentage points over the seven year period.  In fact, the situation for Canada is far worse with the latest statistics showing that Canadian household leverage rates rose to 164.6 percent in the second quarter of 2015, well above the 155 percent (2013 data) used in the study.

The authors note that the continuous rise in household debt is related to rising mortgage debt which reflects four factors; rising homeownership rates, rising real estate prices, tax incentives that favour debt (i.e. mortgage deductibility) and low interest rates.  In large part, rising housing prices can be attributed to readily available mortgages and low interest rates; in rising housing markets, banks are willing to lend more and in low interest rate environments, households are willing to borrow more.

Here is a graphic showing the correlation between the changes in household debt-to-income ratios and the changes in house prices over the years between 2007 and 2013:

There is a strong link between the rise and fall in household debt and the severity of a recession.  The problem with high debt levels, particularly among households, is that the accumulation of debt can make economic growth appear to be robust when, in reality, the growth is debt-fueled.  It is quite clear that a great deal of the increase in household debt since the Great Recession has been created by the ultra-low interest rate policies of the world's central banks.  These low interest rates have lured consumers into levels of debt that will not be sustainable when interest rates rise to normal levels.

Government Debt:

Let's open this section with a graphic showing what has happened to global private versus public sector debt since 2000:

Growth in global government debt-to-GDP has increased by 35 percentage points between 2007 and 2014 compared to a growth of only 3 percentage points between 2000 and 2007.  Between 2007 and mid-2014, government debt grew by $25 trillion with $19 trillion of that being accumulated by the world's advanced economies.  A great deal of this has occurred because of high stimulus spending during and after the Great Recession.  It is key to note that the level of public debt would be far worse if the world's key central banks hadn't kept interest rates at record low levels for a record length of time.

Here are four graphs comparing the percentage point growth in private (in orange) versus public sector (in grey) debt since 2000 for the United States, the United Kingdom and the Euro Area:

Here is a graph showing the same data for Japan going back to 1980:

Japan's public debt-to-GDP ratio of 234 percent is the highest in the world, beating even Greece which has a ratio of 183 percent and Italy which has a ratio of 139 percent.  Japan certainly offers us a glimpse of what could happen in many nations around the world where governments have no hope of or particular interest in reducing their debt levels.  Japan has experienced nearly a quarter of a century of moribund economic growth in a rising government debt environment.  The nation's stock market is stagnant at levels that it experienced back in the mid-1990s as shown on this chart:

Given the current primary fiscal balances, interest rates, inflation and projected real GDP growth rates over the next five years, the authors of the study conclude that the ratio of government debt-to-GDP will continue to rise for many of the world's advanced economies as follows:

Japan - up 24 percentage points to 258 percent
Portugal - up 23 percentage points to 171 percent
Spain - up 31 percentage points to 162 percent
Italy - up 12 percentage points to 151 percent
Belgium - up 5 percentage points to 140 percent
France - up 15 percentage points to 119 percent
United Kingdom - up 11 percentage points to 103 percent
United States - up 2 percentage points to 91 percent

Unfortunately, as I noted above, unless governments are able to maintain fiscal surpluses that are large enough to cover debt services for long periods of time, government debt levels are unlikely to fall.  This will be increasingly difficult to accomplish if interest rates rise, given that a great deal of the current drop in government deficit spending can be attributed to dropping interest rates on current debt as shown on this graph:

The only options that governments have to achieve any semblance of fiscal balance are both painful; cut spending or raise taxes, with both options being unpalatable to most voters and taxpayers.  The option of increasing economic growth to reduce debt-to-GDP levels is hamstrung by the already high public debt levels.

As we can see, the policies adopted by the world's central banks, particularly the Federal Reserve in its position as the world's most influential central bank, have added to the world's debt problem.  By maintaining a very long period of near zero interest rates, both households and governments have been able to accumulate debt with no apparent consequence.  Rather than using an economic boom to reduce debt as would have been done in the past, debt levels have risen significantly during the most recent economic growth cycle.  Once central banks begin to normalize their interest rate policies (if indeed they ever do), the debt "chickens will come home to roost" and we will better understand the real crisis that has been created by the accumulation of ever-higher levels of both personal and public debt, a crisis that will be beyond any monetary policy fix.


  1. Can you tell me - this is a simple request for information - who holds the corresponding credit for all this debt? To whom is it owed - in terms of corresponding nationality and type of entity?

    If the credit holders are content to allow the debt to continue at present rates of interest (as it would seem) why would or should interest rates rise and why should that be seen as 'normalisation' - beyond simple historical comparison?

    If Japan is in such a bad way in terms of both government and private debt, what are the particular answers to the questions above in their national case, and how does the Japanese public presently suffer from the situation - high unemployment, low incomes or what? As the Japanese situation has famously persisted for many years, how is it unsustainable?

    I don't know the answers and these are not trick questions. I should really like to know.